Money and the Financial System: Functions, Measures, and Why Intermediation Exists
What this domain tests
Definitions and the economic logic behind money: why it exists, how the Federal Reserve measures it, and what the financial system does that barter cannot.
Functions of money
Money is defined by what it does, not what it is made of:
- Medium of exchange - eliminates the double coincidence of wants that makes barter costly.
- Unit of account - the common denominator in which prices and debts are quoted.
- Store of value - carries purchasing power across time. Many assets store value; only money is generally accepted in exchange.
Exam items usually describe a situation and ask which function is involved. A price tag is a unit of account; a balance held in a checking account is a store of value; a coin used to buy coffee is a medium of exchange.
Attributes of good money: acceptability, portability, divisibility, durability, uniformity, limited supply, and stable value. Commodity money (gold, cigarettes in POW camps) has intrinsic value; fiat money is inconvertible and rests on legal-tender status and trust in the issuer. Gresham's law: bad money drives out good - when two monies circulate at a fixed legal ratio, people hoard the undervalued one and spend the overvalued one.
Measuring money
Aggregates are ranked by liquidity. M1 = currency in circulation + checkable deposits + travelers checks. M2 = M1 + savings deposits + small time deposits + retail money market mutual fund shares. Credit cards are not money; they defer payment. Debit cards access existing money.
What the financial system does
It moves funds from surplus units (households) to deficit units (firms, governments) through direct finance (securities markets) and indirect finance (intermediaries). It supplies payments services, pools small savings, reduces information costs, diversifies and transfers risk, and creates liquidity.
Worked example
A $1,000 face-value Treasury bill bought for $950 and repaid at par in one year. The discount is $50, but the return is 50/950 = 5.26%, not 50/1000 = 5.0%. Candidates who divide by face value pick the wrong answer.
Traps
Conflating money with wealth or income; treating M2 as more liquid than M1; assuming a store of value must be money; computing yields on the wrong base.